Welcome to the supplemental episode to the main episode about Canadian investment account types. In this episode, we explore some of dilemmas that people face in deciding which accounts to use for investing. Accounts are basically just containers to hold investments. Like rooms in the house that is your portfolio. How do you choose which doors to open and put your stuff into? What if you put it in the wrong room or are afraid of making that type of mistake?
The idea is that you will consider how the situations apply to you. It is not specific advice, but hopefully you can relate to aspects of them and use that in your own thinking or with your advisor.
Case 1: Planning For a Windfall: RRSP, TFSA, or Both?
Case 2: Oops! Wrong Room: Escaping a Group RESP
Case 3: Incorporated Professional Afraid to Use Their RRSP
Transcript
- Intro
- Case 1: Planning for a windfall: RRSP, TFSA, or Both?
- Case 2: Escaping a group RESP
- Case 3: Incorporated Professional Afraid to Use RRSP
Intro
[00:00:02] BF: Welcome to the Money Scope podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital. And Dr. Mark Soth, aka The Loonie Doctor.
[0:00:17] BF: All right, so this is our fourth Case Conference supplemental episode. We hope you’re finding these useful as a complement to the main episodes. These cases are based on common scenarios that often lead people to make poor decisions with their investments. The idea is that you’ll consider how the situations apply to you. Our guidance to the hypothetical scenarios are not specific advice. But hopefully, you can relate to aspects of them and use them in your own thinking with yourself or with your advisor.
[0:00:41] MS: So, we did spend a lot of time in the main episode talking about different registered investment accounts. Despite all of their potential advantages, people can get hung up on some of the dilemmas that go with making the most out of them, because they are complicated. So, we hope to hit up on a few common ones today. With that, we’re going to get started right into our first case, which is about the RRSP versus TFSA decision.
[0:01:04] BF: Oh, yes. This is such a good one, and so important, and so poorly understood. So, I hope you will come away from this with a lot of clarity.
Case 1: Planning for a Windfall: RRSP, TFSA, or Both?
Common Predictable Windfalls
So, we have an employee at a technology company, and they’ve got a $150,000 salary. But a large part of their expected compensation is in the form of RSUs, restricted share units. So, their employer grants them RSUs when they start working, but it takes a year for them to vest. That means they like don’t actually have access to them until they vest. The RSUs are not included in their income until they vest, and then once they do vest, each vesting amount is fully included in their taxable income.
Unless the company’s share price tanks, because usually you’re granted a number of RSUs based on the share price at the time that they’re granted. It’s like a number of shares that you’ll receive in the future. But that means that if the price goes down, your number of shares stays the same, and the value that you get when they vest goes down. Unless the share price tanks, which of course is always a possibility, especially in tech, they expect their total taxable income to be over $500,000 next year.
[0:02:01] MS: Before the eyes glaze over of anybody who’s not part of a tech firm. This is actually – even though it does deal with the special case of these RSUs, this is actually a fundamental issue that’s going to apply to anyone who has a high income that’s still below the top tax bracket, especially if they have a predictable, massive taxable lump of income, bumping them up in the coming year, and that can apply to many situations.
That could be an early physician moving from residency to their early practice, or building up their practice. A corporate business owner, again, investing time in their business, and suddenly they can see that it’s going to start to really take off. And even anybody who just knows they’re going to need to take a big chunk of money out of their corporation for personal consumption over the next couple of years that may bump up taxable income. So, there’s lots of ways this can apply to anyone.
[0:02:48] BF: Exactly. We use the RSUs as an example, because it is one way that this can happen. But it’s one of many, like you said, Mark. So, it is a pretty common issue.
Getting The Most Out of Your RRSP Deduction
Now, we all have limited RRSP room, because you get it based on a percentage of your earned income each year. But you can only get it for a limited number of years, and up to a cap every year. So, it’s really important to get the most out of each contribution, or out of each deduction, I guess, is maybe a better way to say that, because you can make a contribution and then deduct it later.
In the example, the relevant tax bracket in Ontario in 2023, is the over $106,717 up to $150,000 bracket, which is taxed at a combined rate, provincial and federal of 43.41%. So, this means that in this case, each dollar of RRSP deduction reduces your current year taxes by 43 cents by lowering your taxable income. That’s pretty good. But remember that in this case, we expect there’s going to be a big jump in income next year. So, the relevant tax bracket in that case with the income jump is going to be 53.53%. The deduction is clearly more valuable in that future year.
Now, it likely makes sense to use the TFSA room for now, and use the RRSP next year. We can use the RRSP contribution –
Enough for both RRSP & TFSA
[0:04:05] MS: To contribute in this current year. But let’s say you have extra money, you can put money in both your TFSA and your RRSP. Well, you could do that now, and then just not deducted against your income in this current year. Now, that wouldn’t probably apply with this RSU case because they don’t actually get the money. But it could apply to someone who actually, they may have money now, but they’re going to have a big taxable pump in another year.
Sequence If You Have to Choose
[0:04:30] BF: So, in this case, because we know that it’s going to be that big jump in tax brackets, and there’s limited savings. This person is making $150,000. We don’t know what their lifestyle expenses are. We didn’t get into that. But they likely have limited savings. It’s probably going to make sense for them to use their TFSA room, if it’s available, for now. Then, use the RRSP contribution and deduction next year.
It is possible to use the RRSP contribution now and carry the deduction forward. But we don’t want to carry it for too far into the future because there’s have implicit cost to doing so. So, given the choice between using the TFSA, and using the RRSP contribution this year, and carrying the deduction forward to the future, the TFSA is going to be more attractive in that case. Then, next year when taxable income is actually higher, and there’s going to be more liquidity from the RSUs vesting, the RRSP is more likely to make sense.
[0:05:20] MS: Yes. I think that cost of waiting far into the future is important too. This is something that one or two years at a time, not where you have a bunch of unused RRSP room for 20 years or so. That’s way too long. You have no idea what’s going to happen.
[0:05:35] BF: Yes, definitely.
[0:05:35] MS: All right, great. So, I think that’s a very common case that comes up, especially for physicians starting out, or people that are working with firms that are going to give them these RSUs. But the next case is also going to be really common, and this is about escaping the Group RESP.
Case 2: Escaping A Group RESP
So, this case actually describes a number of close friends of mine that’s very common. And it’s funny, because I was actually discussing it a bit with my wife as we were writing the case. And contrary to the usual response of nodding and nodding off, she actually got excited too, because she knows a bunch of people who are, again, in this kind of situation. And it’s one that often comes up when people have learned more about investing, and they realize that maybe they may not have done the best thing, and how can they adjust course.
So, the couple in this case, they’re not physicians, but they’re high-income employees. They have a son who’s now a few years old. When he was born, they got the marketing push from a group RESP, and they signed on to that plan. Over the first four years, they contributed about $2,500 a year. But then, now, after doing some research, they want to use a self-directed individual RESP instead, of the group RESP.
And they’re in a good situation, they have enough cash flow that they could contribute more each year. They just haven’t because that was just part of the contract, and they didn’t really understand how it all worked. They could even contribute up to the lifetime maximum of $50,000. So, they have those resources to actually do something different if they want to. But what would be their options, and the likely consequences of that?
How Group RESPs Work
[0:06:59] BF: These are really complex plans. It’s important to understand how they work. You buy units in the group plan, and those units entitle you to a portion of the group’s future educational assistance payments.
Barriers To Exiting
There are typically going to be large sales charges upfront, which get at least partially recouped if you stay in the plan. That’s really important. Because if you buy units, initially, there’ll be large sales charges that they can actually eat up all of your contributions. So, if you try and exit the plan early on, you might get nothing back. There might be nothing for you. So, you end up being on the hook for those initial upfront costs. Your contributions to the plan, going forward, usually go toward paying the sales charges off, before any money actually gets invested. It’s crazy to think about. So, you put money into this plan, and for the first little while, you’re just paying off sales charges.
[0:07:42] MS: And you’d mentioned too, that actually counts for getting the grants too. So, if you’re putting $2,500 in, but 500 of that goes to paying fees, then really, it’s $2,000 for calculating the grant, not 2,500.
[0:07:56] BF: There’s some detail like that where to get the maximum grants, you actually have to be contributing more than the normal $2,500 that has to go in. So, yes, that’s another crazy thing about this.
The other unique aspect is that if you stay for the full duration of the contract, you actually get to participate in some of the earnings that people who left early gave up, which is also crazy. So, these things are, they’re predatory, right? Where if you leave, you get screwed. But if you stay, you benefit from the people who got screwed.
[0:08:24] MS: And you don’t know how that balance is going to go.
Impact of Time in the Plan
[0:08:25] BF: Yes, true. Okay, so with that, as a setup, what to do when you realize that you’re in one of these plans is going to depend on where you are in the life of the plan. So, you’ve had this realization that I’ve learned something that maybe these group RESP plans are not so good, but I’m in this contract. What do I do?
If you’re within the first 60 days of the contract, you can typically get out without any penalties. So, this just happened, as it tends to like, right when you’re in the hospital, you’ve just had a baby, they’re predatory that way. You’ve just enrolled in the plan within 60 days, you can probably get out. So that’s the best-case scenario.
If you’re past that, and within the first couple of years, you can run the numbers and the trade offs between the cost of exiting the group plan and the higher expected returns of a self-managed RESP account, because there’s going to be a cost to exiting. But then if you set up a self-directed RESP, or an RESP, with a financial advisor, the costs are typically going to be much lower, and the expected returns on the investments available to you are typically going to be much higher. That depends a little bit on your risk tolerance and stuff like that. But it’s still a scenario that can be run.
The answer there is going to depend on your assumptions, like expected returns, as I just mentioned. But if there are a lot of years ahead in the plan, so this is again, if you’re early on in the group plan, there’s a good chance it’s going to make sense to exit and eat the penalty costs. If you’re more than midway through the contract. This is where it starts to get really tricky, because later on in these plans, you’re typically going to get a large portion, often up to 50% of your fees rebated. Then, you may also get that windfall that we talked about earlier from the foregone returns from the other contract holders who have decided to leave the plan early. And you’re also going to have fewer years left for higher expected returns to make up the difference in that case.
So, if you’re much later in the plan, you can still run the numbers, of course. But there’s a good chance that if you’re more than halfway through the contract, that it’s going to make sense to stick it out.
Opening a Secondary Self-Directed RESP
[0:10:09] MS: Yes. Sticking with the existing group plan or exiting depends on how far along you are into it. However, you aren’t obligated to make further contributions, could you open a secondary RESP, and then take advantage of some of that extra tax-sheltered room up to the $50,000 lifetime limit? Even though you may or may not get extra grant money, depending on how much you are obligated to put into that group area span. Could you do that as a different way of not making even more money into that?
[0:10:35] BF: Yes. It’s definitely possible. I think it’s really important to understand the group RESP contract that you’re in. These contracts are just bricks of text and it’s a contract. So, you’ve got to read and understand the implications is doing different things.
[0:10:48] MS: Yes. We read a few of those in preparing for this.
Minimizing Contributions to the Group RESP
[0:10:50] BF: Not the most exciting reads. So, they’re set up so that you buy a number of units in the plan when you open it. Then, that comes up with the upfront sales charge that we talked about. The sales charge is a fixed amount based on those initial units. It’s spun as a sales charge per unit decreasing as you purchase more, but it’s really just a sunk cost and it gets diluted as you contribute more money. You can usually decrease the ongoing contributions down to a minimum by reducing the number of units in your plan, but you’re forfeiting your contributions on any growth on those units. Your contributions and any growth on those units.
If you opt to minimize your contributions, by reducing your units, you’ve got to be sure to use their form to do that. You don’t want to skip payments, because that can mean defaulting on the contract, which comes with big penalties. There’s usually a fee for decreasing the contribution schedule. Anyway, you’ve got to be really sure to read the fine print of the contract you’re in. Or if you have a financial advisor, this is probably something that they can review the contract for you. I learned a lot about this by talking to a friend of mine who’s just for whatever reason, he’s seen a lot of these, he spent a lot of time with clients who have come to him with these plans. So, he’s spent a ton of time reading the contracts, and he had a lot of interesting little nuanced details, a lot of which we’re talking about here.
But similar to exiting the plan entirely, minimizing your future contributions might be another avenue to avoid, continuing to throw good money after this bad contract.
Be Sure of How Much You Can Contribute to the Second RESP
Once you’ve minimized or exited the plan, you can then open a separate self-directed RESP and invest using that. You still can’t exceed the lifetime contribution limits. So, you’ve got to be able to check to make sure that you’re on side with that. The Canada Education Savings Program has a 1-800 number that you can call. They pick up the phone, they’re super responsive, and they give you the information.
An interesting point is that the CESG grants are paid based on the date of transaction. So, if you make your contribution to your self-directed RESP, you may be able to get more of the grants into it before the group plan uses them. But again, you’ve got to make sure that doing that doesn’t violate the contract with the group RESP.
[0:12:47] MS: Lots of nuances in there. But this is big money we’re talking about too, for a lot of people. So, it’s worth exploring, for sure.
[0:12:55] BF: Yes, definitely.
Case 3: Incorporated Professional Afraid to Use Their RRSP
[0:12:56] MS: That brings us up to our third case. So, this is another really common one that I see all the time. This is fear of the too-big RRSP retirement savings plan. And it’s an area where there’s common pushback for people who are incorporated.
When an RRSP is a Tax-Free Shift Out of the Corporation
One of the common areas is that I see a lot of colleagues, they have this huge amount of unused RRSP contribution room. I mean, they’ve taken T4 income from their corporation over the years, so they have the room, they just haven’t used it. They could use it. They could pay themselves a T4 for income bonus from their corporation to fill that unused room. And because it’s considered a salary type of expense, it’s a corporate expense, and there’s no corporate tax to do that. The RRSP contribution has a personal deduction dollar for dollars, so there’s no personal tax either.
This is actually, essentially, a tax-free shift of money from the corporation to an RRSP. There’s no tax penalty for doing that. But they still haven’t used it because their accounts told them that you should just keep everything in the corporation, let it all grow there, and avoid using their RRSP. It’s always puzzled me and I’ve tried to figure out why that is.
RRSP & Corporations Both Have “Forced” Withdrawals
I’ve heard two main arguments to make that point. One is that you’re eventually forced to take money out of an RRSP. It gets converted to an RRIF, and then you have to take a little bit out each year. The argument is in contrast, if you have all your money in a corporation, well, you get to decide how much comes out each year, you don’t have to take out a minimum each year.
Before the age of 72, you have to start taking out a small percentage of an RRSP each year. For example, if you had a million-dollar RRIF at age 72, you would have to take out $54,000 that year. It’s the percentage and it’s tied to the value of the account, and it slowly ramps up to 20% if you’re still alive and there’s money left over at the age of 95. I mean the idea is to gradually take money out of this and not have it be huge when you die. That’s the reasoning behind it.
That’s good reasoning because you actually do need money to live on. So, this whole notion that you’re going to just leave your money in your RRSP and never touch it. Even when it’s an RRIF, it doesn’t make a lot of sense, because you’re actually going to need money to spend and there’s no point in dying with this huge pile of unspent money. That may not be smart move on its own for many reasons.
The other side of that argument that I find a bit misleading is this argument that you can control the income coming out of a corporation. I mean, yes, you can. You can decide not to pay money out of your corporation, However, eventually you will have to pay money out of the corporation or you’re paying tax on that upfront anyways. So, the way corporate investing works, and we’re going to talk more about this in our corporate investing episode, the passive income that’s there gets taxed at a higher rate up front, pretty close to the highest personal tax rate. Some of that money gets refunded when you flow the money out of the corporation and then pay personal taxes on it.
So yes, you can decide not to do that, I guess. But then you’ve decided you’re just paying high taxes up front. It’s not really a decision to make. So, whether it’s a corporation or an RRSP, you’re eventually going to have to take the money out of it each year. That argument, I don’t think makes a lot of sense to me, really.
RRSP May Cause Less OAS Claw back Than Dividends
The other thing I would say is that taking dividends out of your corporation, those dividends get grossed up, which means they get multiplied by a factor of 1.15 for a small business, or 1.38 for an eligible dividend, and that higher amount of income then gets applied against your personal tax rates. But it also results in OAS claw back. So, taking money from an RRIF, may not have as much OAS claw back as taking it from your corporation does.
Tax Sheltering Makes It Hard to Have a “Too Big RRSP”
There is all the big focus on tax deferral. That’s what’s underlies this argument. But I think the other part that’s missed in that equation is, besides tax deferral, the RRSP also has tax sheltering, too.
So, all of that investment income that you’re growing in an RRSP, which you’ve essentially in this case, shifted from your corporation has shifted from an environment where it is actually taxed. Dividends, interest, and realized capital gains are all taxed to the year that you have that. Whereas in an RRSP, all of that’s not taxed. Now, deferred capital gains in a corporation can be very, very tax efficient, but other income may not be.
So, I think the second argument used to grow too big of an RRSP and forced take out a higher tax bracket gets you up, tangled up in these OAS clawbacks as well. And that could be effectively a 15% tax increase. That’s the rate that it gets clawed back at, and that may not affect everybody, but it’s going to affect people that have a taxable income in the $87,000 to $140,000-year range. That would catch a lot of people.
We did mention in the main episode that tax deferral can actually cut both ways. This idea of a too-big RRSP, you’re deferring tax to the future. But what happens if your future tax rate is higher? Are you hurting yourself by making this big RRSP? So, Ben, you’d actually discuss this notion of a too-big RRSP in Rational Reminder Episode 70. Could you give us some of the highlights of that analysis?
[0:17:43] BF: Definitely. That was a lot of fun to do, that analysis, and I will talk about it. But I want to say real quick that your point about controlling the income from a corporation is so good. I just want to reiterate it to make sure that listeners get it. With the RRSP, you are forced to convert your RRSP into a RRIF at age 71 and start making withdrawals at age 72. And people get scared about that, because it’s something that you have to do.
With the corporation, you don’t ever have to make withdrawals, except maybe that there’s a disposition on death. But during life, you never are forced to take withdrawals unless you need to spend money to live. But by earning investment income inside the corporation and not taking any dividends out as distributions, you are penalizing yourself, because your corporation pays tax at 50.2% rate in Ontario on investment income.
And if you don’t pay yourself any dividends, there’s this big chunk of refundable tax that’s just going to sit there, and there’s an opportunity cost of doing that. So, while you’re not forced to take money out of the corporation, you are incurring a significant economic cost by not doing. That’s just such a good point and so important people understand that in one case, you’re forced to take money out. In the other case, you’re not forced, but you’re eating an economic cost if you don’t.
[0:18:54] MS: Yes. And no one ever talks about that.
[0:18:56] BF: It’s a really, really good and important point, because it’s super common. It is super common for some people to just say, “Well, no. We’ll leave everything in the corporation because it gives you more flexibility and whatever, whatever.” But flexibility can come at a cost.
So, in that Rational Reminder episode 70, we did an estimate of how much higher your tax rate would have to be in the future to make the RRSP put you in a worse position than having invested in a taxable account. Taxable investments, as we’ll talk about in the next episode, they’re going to have tax drag every year and a taxable capital gain in the future. Then we also have to remember that like the TFSA, the taxable investments are made with after-tax dollars. So, if we take a $50,000 investment in a taxable investment account, earning a 2% fully taxable income yield, plus an unrealized capital gain of 3%, and then we assume that the RRSP also earns a total return of 5%. Though in that case, none of it is taxable inside of the RRSP account. The after-tax return on the investment assuming a 50% tax rate is 4% per year, but then we also have the unrealized gain to deal with in the future. So, after paying tax on the gain, again at 50%, we’re left with just under $100,000, after 20 years.
Now, to get the same result from the RRSP. So, that was a taxable account. To get the same result from the RRSP, we would need to have a future tax rate that is 13.5% higher than the tax rate when we made the contributions. So, a 63.5% tax rate. Now, that math is going to work slightly differently for lower starting tax rates as the taxable investments get more tax efficient, with lower levels of taxable income from other sources. With those numbers in our example, at a 50% starting tax rate, as long as the future tax rate is not more than 13.5% higher than the current tax rate, the RRSP is still going to be better than a taxable account. And then at lower levels of steady income, that number is going to be smaller.
The big takeaway here is that if you’re starting out in a high tax bracket, it would take a lot for an RRSP to genuinely get too big, unless it’s going to be the one factor that results in OAS clawback. Then even then, I think it’s something that could be addressed before it became an issue. So, if you realize that an RRSP is too big, before you start taking your old age security, or before you have to convert your RRSP to a RRIF, you can make some early withdrawals from the RRSP.
Using Multiple Accounts Gives More Tax Planning Options Later
[0:21:10] MS: Yes. I mean, that gets into another great point, which we’re not going to cover in this episode, but we will later. If you have multiple pots of money, like an RRSP and a TFSA, a corporation, and a taxable account, you have a lot of options about the mix that you take when you’re drawing down your money.
If you can plan about what that’s going to look like now, and then during the years when you have OAS as an issue, and then towards death, you can actually change the sequence and the mix that you’re drawing from those different accounts. It actually gives you a lot of flexibility to minimize the overall tax bill planning around it. So, there’s lots of ways to get around that. And even be able to plan and take money for things like a one-off splurge expense, like you buy an RV, or a car, or cottage, or something.
Diversification Against Tax Legislative Changes
So, having that flexibility of using multiple accounts, is probably a lot better than just having everything in one account, even if it’s a corporation. The other point I would say too with this, is if you want to diversify your portfolio, not just against the specific risks of the investments, but also the tax changes that can come with all these different accounts.
We’ve already seen this happen to corporate accounts once where the tax laws are changed, and generally not going to be in a favourable way, because very few people have corporations. They’re a small part of the voter population, but a lot of people have RRSPs, and TFSAs, and if you start touching that, politically, it’s going to be a nightmare.
So, spreading out your wealth, rather than just having a concentrated one account probably has a benefit on its own, in addition to the fact that you’d really have to have a much higher tax rate in the future for the RRSP not to be beneficial to you.
[0:22:38] BF: Oh, yes. The bucket diversification, if we can call it that, is such an important point too, because we’ve even seen the changes in how passive income rules affect the taxation of corporate active income that was not always a thing. If you were someone who had not used your RRSP, or your TFSA, and you’ve had all of your savings inside of your corporation, that puts you at somewhat of a disadvantage relative to somebody who had been using their registered accounts, because that increased your passive income relative to the alternative scenario.
So yes, that’s a great example there of how legislation can boom with the snap of a finger, make a concentrated strategy, where concentrated means all of your assets in one bucket can make it suboptimal really quickly.
[0:23:18] MS: Great. Well, yes, we’ve covered lots of territory with those cases, and thanks for joining us and hope you will join us again for our next episode that we’ve got coming up.
[0:23:26] BF: So, this is our Case Conference for episode eight and we will see you in our next episode nine on the basics or not-so-basics of investment taxation.
[0:23:35] MS: The basics and plus.
[0:23:36] BF: Yes, basics plus. All right.
Related Resources
Rational Reminder Episodes
Too Big RRSP Segment
Loonie Doctor Blog Posts
RESP Basics
Learn how an RESP works. You can open a self-directed RESP and take full advantage of this gift from the government. Without the fees, restrictions, and low returns of a group plan. Get tax-sheltered growth, grants, and free kittens.
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